Soft commissions in Britain

Hard to stop

ONLY two out of 200 pages in Paul Myners's recent, sweeping review of institutional fund management in Britain discuss the matter of stockbroking commissions. Yet his recommendation that fund managers should pay for the services that stockbrokers provide, rather than pass the cost on to the corporate pension funds they run, has become the most hotly debated of his reform proposals. Even executives at Gartmore, the investment-management firm that Mr Myners chairs when he is not writing reform plans for the chancellor of the exchequer, have criticised their boss for this proposal. The Fund Managers' Association has been positively alarmist, giving a warning that British fund managers would be at a competitive disadvantage if they had to pay brokers for their services.

Why are the ways brokers are paid so controversial? There are two sorts of broking commissions: the usual percentage of a share trade and “soft” commissions. There are also two types of brokers: full-service brokers and soft ones. Old-fashioned, full-service brokers, such as Cazenove, get a “traditional” commission on each share transaction, for a bundle of services that include research as well as the execution of the transaction. Soft brokers work differently: they provide fund managers with inducements—say, a Reuters screen or research reports—in the hope that fund managers will channel business in their direction. If they do, the broker recovers the cost of the inducement, and with luck more. If the fund manager cannot use or does not want the services of the soft broker, he will lose them or may even get an invoice for the Reuters screen at the year's end.

Mr Myners campaigns for a fund-management fee that is all-inclusive, and for an end to the practice of “softing”. In his view, fund managers, being human, are less conscious of costs when they choose a broker, because the bill is now picked up by the pension funds they manage. He thinks fund managers prefer to use a broker's proprietary research (however mediocre), rather than hire their own research analysts, because they would have to pay these directly.

Soft commissions create an even stronger bias for fund managers to rely on the services of brokers. A fund manager will be reluctant to consider switching from a broker who offers soft credit, even if the service is better elsewhere. And he will be tempted to shuffle a client's portfolio rather more often than necessary. Each trade generates a commission and is therefore a step closer to paying off the Reuters screen.

Many fund-management firms and stockbrokers in Britain are jumping to defend the present system. They argue that high commissions affect a fund manager's performance, which is measured after all charges, including commissions. Fund managers are thus likely to be careful not to overpay brokers, they say, even if it is other people's money that they are spending. They say a radical overhaul of the commission system in Britain makes little sense when America, the world's largest equity market, will continue with today's arrangements, soft commissions and all. (Softing is more generous and more widely used in America than in Britain.) To have a different commission system from international peers would put British fund managers at a disadvantage, or so say London money-men. At the least, they would have to put up their management fees.

Soft commissions have fewer defenders than traditional commissions (the two are not incompatible, of course). Some fund managers do not engage in softing—on principle, they say. Still, soft commissions are less murky than their reputation has it. In Britain, the Financial Services Authority tightly regulates soft commissions. Brokers and fund managers must declare them, like any other form of commission, as they do in America. Moreover, an end to soft commissions would put some agency brokers out of business, so reducing diversity in the market. It would disadvantage small fund-management start-ups that badly need initial help from soft brokers. Not everybody thinks that the trend towards a handful of huge fund-management firms is a healthy one.

Mr Myners is undeterred by these arguments. In his eyes, Britain should pioneer a system that provides better value for money. Many of the commissions, hard or soft, that pension funds end up paying go, for instance, into research reports that lie unread. One of fund managers' most frequent complaints is over the huge quantity and poor quality of research from financial behemoths that are keener to please their investment-banking clients than to provide critical research. Investment banks' conflict of interest helps explain why a recent survey of fund managers, by Tempest, a consultancy, found that many managers increasingly resort to their own, in-house research, despite its extra cost.

Mr Myners's proposals would encourage this trend. More fund-management firms would then have in-house trading desks, or use brokers who simply execute deals. In addition, they would become more selective about buying outside research reports. You can see why the stockbrokers oppose the report. Mr Myners has taken on a powerful lobby. He has the backing of the chancellor of the exchequer, but not even Gordon Brown can make fund managers subscribe to a “voluntary” new code of practice to which they are opposed.